H. Alternative Investments: the basics which are the building blocks for myriad strategies. Nominally alternative investments in the CFP® Board of Standards Topic List, discussed below are actually derivatives, so named as their value is derived from the underlying investment upon which they are based.

Derivatives- options, futures/forwards and swaps are the building blocks for an untold number of strategies to hedge the risk and enhance the return on portfolios. Because the usage of swaps is most typically reserved for institutional portfolios, our discussion focuses on options, futures/forwards and warrants/rights

Options - options provide investors with a potentially cost-effective way to hedge risk and enhance return. They may be both standardized and custom tailored. Candidates should expect questions on the drivers of options' value, rather than on how to calculate the actual value of an option using the Black-Scholes model. Additionally, the candidate may encounter a few questions asking him or her to identify an option's or option strategy's intrinsic and time value as well as the maximum gain and loss or the break-even point.

An option is a two-party contract conferring a right upon the buyer and an obligation upon the seller. The Options Clearing Corporation (OCC) standardizes contract terms, enabling them to be traded easily on exchanges such as the Chicago Board Options Exchange (CBOE). Examples of underlying securities may be a stock, stock market index, interest rate, foreign currency or government bond.

Terminology

Type - calls and puts.

Call - the buyer has the right to purchase shares at the strike price.

Put - the buyer has the right to sell shares at the strike price.

Class - the calls or puts of one issuer are classes of options.

Series - class, exercise (strike) price and expiration month.

Style -

American Style - buyers may exercise at any time prior to expiration.

European Style - may be exercised only on the business day prior to expiration.

In-the-money - a call option is in the money if the current share price is greater than the strike price. The holder of the option can purchase the stock as the strike price and sell it at the higher current market price. Conversely, a put option is in the money if the current share price is below the exercise price. The holder of the put can shell the shares at the strike price which is greater than the market price, limiting his or her loss.

Out-of-the-money - for calls, the strike price is greater than the market price; for puts, the strike price is lower than the current market price.

Intrinsic Value - is the amount by which the option is in the money. If a call option's strike price is $45 and current market value per share of the stock is $50, the option's intrinsic value is $5.

Time Value - when investors buy options, they pay a premium which reflects the option's intrinsic or in-the-money value and the time premium or the market's perception of the value of the option's time left to expiration. For example, a put option's strike price is $73, the price of the underlying stock is $67 and the premium for the option is $8 which consists of $6 (the in-the-money amount or $73-$67) and $2 worth of time value.